Section 2: The Case for Free Trade: The Law of Comparative Advantages

The well-known classical economist, David Ricardo (1772 – 1823; pictured), demonstrated that it is beneficial for each country to specialize, even if one country produces all products more efficiently. He suggested that each country produces the goods at which it is comparatively best. He called this the “law of comparative advantages.”

The Law of Comparative Advantages

If one country is better at making all products, should it make all products and not trade with anyone? Or is there still an advantage for each country to specialize and trade? To examine this, let’s understand the concept of comparative advantage.

A country has a comparative advantage in producing a good when it produces a good most efficiently relative to the production ratios of the same goods produced by another country.

A Numerical Example of Comparative Advantage Trade

The following numbers represent hours of production needed to manufacture 1 barrel of oil and 1 watch, respectively.

China

Nigeria

Oil

30

10

Watch

40

20

Problem: Nigeria is more efficient in producing both oil and watches (and assume for simplicity that the wage rates in both countries are the same). Which country has the comparative advantage in producing oil? Which country has the comparative advantage in producing watches?

Solution: Nigeria is 3 times as efficient (10 hours versus 30 hours) than China in producing oil. It is 2 times as efficient (20 hours versus 40 hours) than China in making watches. Therefore, Nigeria has the comparative advantage in producing oil, and China has the comparative advantage in making watches.

For Nigeria, producing 100 barrels of oil uses the same number of hours (100 times 10) as producing 50 watches (50 times 20). Therefore, if Nigeria specializes in and produces 100 additional barrels of oil in exchange for producing 50 fewer watches, it will employ the same resources.

For China, producing 60 watches uses the same number of hours (60 times 40) as producing 80 barrels of oil (80 times 30). Therefore, if China specializes in and produces 60 additional watches in exchange for producing 80 fewer barrels of oil, it will employ the same resources.

Problem: If both countries specialize in the manner described above, by how much will total world production increase?

Solution: Total world production of oil increases by 20 and total world production of watches increases by 10 (see table below).

Nigerian oil

+ 100

Nigerian watches

– 50

Chinese oil

– 80

Chinese watches

+ 60

Additional oil production

+ 20

Additional watch production

+ 10

Another Example

Let’s consider two countries, England and Chile, and let’s suppose that production consists of only 2 products: wine and cloth. England produces one unit of cloth in 2 hours and one bottle of wine in 20 hours. Chile produces one unit of cloth in one hour and one bottle of wine in 5 hours. Chile is better at making both products. However, it is best (it has a comparative advantage) at making wine. Chile is twice as efficient in making cloth and 4 times as efficient in making wine. If Chile specializes in making wine and chooses to make, for instance, 10 more bottles, it must give up 50 units of cloth. If England produced 60 more units of cloth, it would give up 6 bottles of wine. Total production increases!

Specialization and Trade Lead to an Increase in Standard of Living

Even in the case where one country is better at making all products, it is beneficial for countries to specialize and trade. After specialization, without each country having to use any additional resources, and after sharing the additional products, each country is able to increase its standard of living.